Fresh Start Attainable for Bankrupt Small Businesses

Comparing small businesses that have previously filed for bankruptcy to those that have not gone down that road, some firms are no more burdened than others by poor cash flow, high health insurance costs or excessive taxes.

The Small Business Administration’s Office of Advocacy offered that conclusion in a new report, “Beyond Bankruptcy: Does the Bankruptcy Code Provide a Fresh Start to Entrepreneurs?” Firms are surviving years after the filing, according to the report. The data also showed that there is little to distinguish these firms in terms of firm size, as measured by employment.

“Small businesses filing for bankruptcy have an opportunity for a new start. This new start is hampered by the challenges of obtaining new loans. This can impede innovation and job creation,” said Winslow Sargeant, chief counsel for the SBA’s Office of Advocacy.

Small businesses that filed for bankruptcy have a 24% higher likelihood of being denied a loan and are charged interest rates at least one point higher than other firms. The report also found that firms owned by African and Latino Americans are even more likely to be denied loans and charged higher interest rates.

Owners of previously bankrupt firms are less likely to own credit cards and are more likely to look for outside financing from venture capitalists. The SBA said credit access remains an area of concern too. Firms with a bankruptcy record are rationed out of the market with loan denial rates nearly three times higher than other firms, according to the report.

By the time failing businesses file for bankruptcy, they have usually been delinquent on their payments for extended periods or have been in outright default, the data showed. Therefore, their credit score is likely to already reflect these missed payments and creditors would take this into account before making loans.

Credit unions and other lenders are understandably concerned with how these businesses will impact their financials. Aparna Mathur, the author of the report, said credit rationing may arise if the price affects the nature of the transaction. For example, if the interest rate is set high, then adverse selection would lead to only the most risky borrowers obtaining loans at a certain rate, she wrote. Raising the interest rate decreases the return on projects that succeed. One of the consequences could be that higher interest rates induce firms to undertake projects with lower probabilities of success but higher payoffs when successful.

“Since the bank cannot directly control the actions of the borrower, the objective function facing the bank is to design the loan contract in such a manner that it attracts low-risk borrowers and successful investments,” Mathur said.

The report looked at data from the National Survey of Small Business Finances. The surveys of firms with fewer than 500 employees were conducted by the Federal Reserve Board for data years 1993, 1998 and 2003, looking at 4,000 firms for each year tracked. Mathur said one disadvantage of the data is the exact year of the bankruptcy filing is not known for the firms looked at. It is likely that the consequences of a bankruptcy are worse in the period immediately following the filing and are likely to get mitigated over time, she offered. Profitability, employment and financing are likely to show up as problems in the long term since a filing stays on a firm’s credit record for at least a seven-year period.

During the 1993 survey, the data showed in the credit market, the average interest rate on loans was 8.77% and the loan denial rate was 15.5% for firms that had filed for bankruptcy. The average interest rate on loans was 0.67 percentage points higher than 1993 and loan denial rates were 1.7 percentage points higher that year. Mathur said it appears that there was a tightening in credit markets during this time.

In 2003, the credit market started to ease, with the average interest rate on loans dropping by nearly three percentage points and the loan denial rates decreasing by 10 percentage points relative to 1998.

“This is interesting since it reflects the generally easy credit market conditions of that period which have been blamed for the subsequent financial crisis,” Mathur said. “This suggests that small businesses also benefited from these policies by paying lower interest rates and getting a higher fraction of loans approved.”

Another finding revealed that smaller firms with less than 20 or less than 50 employees obtained interest rates that were approximately 0.7 and 0.4 percentage points higher than the average rate for the period of the respective surveys. Unincorporated businesses, such as partnerships and sole proprietorships, were charged higher interest rates than the average business.

Mathur acknowledged that the report’s data prior to 2005 could have produced different conclusions since Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005 with the intention of making it harder for individuals to file a Chapter 7 bankruptcy. Still, she said, the legislation’s passage would have had a marginal impact on the report’s ending.

“While it influences the choice of chapter for a failing business by pushing relatively more individuals toward Chapter 13, it might have little influence on the outcome,” Mathur said. “Businesses that are forced to reorganize and repay a portion of their debt are as likely to face problems of credit access and firm survival as businesses that file under Chapter 7.”